01 POWER ISLAND / 01 CCPP / DOE_Global LNG Fundamentals_15.03.18

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LNG Reference Market Price

As noted in the previous section, LNG pricing is following the global trend that has been underway for many decades, whereby instead of being priced relative to oil, it is starting to be priced based on a variety of established and emerging global reference prices. This is generally referred to as "gas- on-gas" pricing as it is a measure of the relative supply and demand in natural gas markets, independent of whether the oil market is in balance or not. From an economist's point of view, this would be the established way to set the appropriate market clearing price for a globally traded commodity.

The U.S. Market

The historical rationale for gas reference pricing emerged from the development of a liquids wholesale market in the U.S., with exchange-traded futures contracts to support a pricing mechanism that was not vulnerable to undue influence from a single buyer or seller, and was derived from a transparent, market-based mechanism. Historically, natural gas prices were fixed by the government, but in 1992, the Federal Energy Regulatory Commission (FERC) issued its Order 636. Prices were decontrolled and interstate natural gas pipeline companies were required to split-off any nonregulated merchant (sales) functions from their regulated transportation functions. This unbundling of gas contract pricing and transportation contract pricing meant that exchange-traded gas contracts, based on Henry Hub and other secondary hubs, were established, and the industry moved to market-based indices for pricing purposes.

The European Market

In Europe, this same trend was first established in the UK, following gas market deregulation in the mid-1990s, and the emergence of National

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Balancing Point (NBP) pricing, which, though similar to Henry Hub, is not a physical place. In Continental Europe, the so-called Title Transfer Facility (TTF) has now become an equally dependable mechanism for long-term pricing, though Southern Europe is still transitioning to a mechanism of gas- on-gas pricing, as new hubs start to emerge.

The Asia-Pacific Market

The first signs that a new pricing basis was emerging for the Asia-Pacific region occurred in the early 2010s with the signing of Henry Hub-based LNG tolling contracts. At the time, buying gas in the U.S. and paying a tolling fee to put it through one of the emerging LNG liquefaction facilities, represented a lower landed price in Japan and other SE Asian countries, compared to traditionally oil-priced gas.

A number of attempts are being made to establish a pricing index for the Asia-Pacific market, including the so-called JKM index (Japan-Korea- Marker) and also the Singapore Gas Exchange (SGX) spot price index known as SLiNG, which is intended to represent an exchange-traded futures market for LNG based on gas being traded at or around the Singapore LNG facilities. At the time of writing, no index exists that is considered sufficiently dependable for use on long-term contract pricing in Asia.

Current Developments

The LNG sector has been relatively slow to move away from oil-based pricing. There are many reasons for this, but the main brake on pricing change for LNG has been the lack of availability of a reliable, transparent pricing reference for gas, similar to Henry Hub or NBP, in the Asia-Pacific region, which accounts for about two-thirds of LNG consumption.

The other feature of LNG, compared to pipeline gas, is that it is bought and sold in single ship-borne cargoes, instead of being commingled within a pipeline system, and this too has tended to slow down the development of gas on gas mechanisms.

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In Europe, over the last decade, the majority of traded gas has now migrated from oil-based to gas on gas based pricing, and some

commentators believe that gas-on-gas based pricing will gradually replace oil-based index pricing, particularly as new LNG projects bring additional LNG into the global markets.

An increasing number of countries are considering moving to LNG imports, or establishing relatively smaller scale projects. Because these are under development and/or negotiations, no pricing has been established as yet.

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Price Indexation

Natural gas may be sold indexed to the price of certain alternative fuels such as crude oil, coal and fuel oil. The natural gas feedstock prices into the LNG plants are sometimes indexed on the full revenue stream of the LNG plant including LPG and propane plus (other gas liquids), as in the case of the 2009 amendment of the NLNG contract in Nigeria. Such a pricing mechanism is markedly different from the one found in traded gas markets, where price is determined solely by gas demand and supply at market areas or “hubs.”

In the United Kingdom, around 60% of the gas is sold at the National Balancing Point (NBP) price and the rest at an oil index price based on old long-term contracts. The oil-indexed and hub-priced contracts co-exist.

On the European continent, the case is different. Oil-indexed contracts dominate, with hardly any hub-priced long-term contracts. The continental markets are mainly supplied on a long-term take-or-pay basis. However, a number of short-to-medium contracts do exist which are either fully or partially hub-priced.

Crude Oil Prices

Different crude oil prices are used for the oil index in LNG long-term contracts such as:

Japanese Custom Cleared crude (JCC)

JCC is the average price of crude oil imported into Japan and published by the Japanese Ministry of Finance each month. The JCC has been adopted as the oil price index in LNG long-term contracts with Japan, Korea and Taiwan. LNG pricing for China and India is also linked to crude oil prices

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but at a discount to Korea and Japan. The discount reflects the fact that China and India, although short of natural gas supplies have other sources of natural gas that LNG complements. As a result, China and India have some additional market leverage in negotiating contracting terms.

Average Price of Indonesian Crude Oil (ICP)

PERTAMINA uses the average price of Indonesian crude oil (ICP) for the supply of LNG from the Bontang and Arun plants.

Dated Brent Crude

Dated Brent is a benchmark assessment of the price of physical, light North Sea crude oil. The term "Dated Brent" refers to physical cargoes of crude oil in the North Sea that have been assigned specific delivery dates, according to Platts. Kuwait, Pakistan, and many European LNG prices are indexed on Brent.

Coal Indexation

In markets where gas is used to fuel power generation, some LNG buyers have pushed for LNG indexing against substitute fuels such as coal. Coal indexation has been used for many years in a Norwegian gas sales contract to the Netherlands and is also an indexation parameter in the Nigeria NLNG contract to Italy. This parameter may become more common if clean coal technologies are used to satisfy incremental baseload electricity demand, or if electricity generators come under increased pressure to reduce carbon emissions.

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Oil Indexed Price Formula

Approximately 70% of world LNG trade is priced using a competing fuels index, generally based on crude oil or fuel oil, and referred to as “oil price indexation” or “oil-linked pricing."

In the Asia-Pacific region, LNG contracts are typically based on the historical linkage to JCC. This is due to the fact that at the time that LNG trade began, Japanese power generation was heavily dependent on oil so early LNG contracts were linked to JCC in order to negate the risk of price competition with oil. The formula used in most of the Asia LNG contracts that were developed in the late 1970s and early 1980s can be expressed by:

PLNG = α x Pcrude + β

Where:

PLNG = price of LNG in U.S.$/mmBtu (U.S.$/GJ x 1.055)

α= crude linkage slope

Pcrude = price of crude oil in U.S.$/barrel

β= constant in U.S. $mmBtu (U.S.$GJ x 1.055)

Historically, there was little negotiation between parties over the slope of the LNG contracts, with most disagreements centered on the value of the constant β. Following the oil price declines of the 1980s, most new LNG contracts incorporated a floor and ceiling price that determined the range over which the contract formula could be applied.

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Since suppliers had to make substantial investments in LNG liquefaction trains, a pricing model developed that provided a floor price. For suppliers, this floor limits the fall in the LNG price to a certain level, even if the oil price were to continue falling. Conversely, buyers are protected by a price cap, which restricts LNG price rises when oil prices rise above a certain point.

More recently, the historic price linkages to oil have been called into question as more LNG supply comes on the market from new LNG exporters, such as the United States, which developed a pricing mechanism linked to U.S. Henry Hub. At the same time, the traditional LNG buyers, such as Japan, have balked at new contracts linked to oil, claiming they no longer make sense. As the LNG market continues to evolve, there are likely to be more and more creative solutions to pricing LNG.

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Spot and Short-Term Markets

In recent years, LNG markets have seen the emergence of a growing spot and short-term LNG market, which generally includes spot contracts (for immediate delivery) and contracts of less than four years. Short-term and spot trade allows divertible or uncommitted LNG to go to the highest value market in response to changing market conditions. The short-term and spot market began to emerge in the late 1990s-early 2000s. The LNG spot and short-term market grew from virtually zero before 1990, to 1% in 1992, to 8% in 2002. In 2006, nine countries were active spot LNG exporters and 13 countries were spot LNG importers.

Due to divergent prices between the markets in recent years, the short-term LNG market has grown rapidly. By 2010, the short-term and spot trade had jumped to account for 18.9% of the world LNG trade. In 2011, the spot and short-term again recorded strong growth, reaching 61.2 MTPA (994 cargoes) and more than 25% of the total LNG trade. Asia attracted almost 70% of the global spot and short-term volumes primarily due to Japan’s increased LNG need following the March 2011 Fukushima disaster, which took Japan's nuclear reactors offline. A large portion of the lost power generation capacity was replaced with generators fueled by gas imported as LNG. Spot and short-term LNG imports into Korea almost doubled (10.7 MTPA) and almost tripled for China and India with both countries importing a combined 6.5 MTPA of LNG.

By the end of 2011, twenty-one countries were active spot LNG exporters and 25 countries were spot LNG importers. The growing number of countries looking to participate in the spot market is indicative of the increased desire for flexibility to cope with market changes, unforeseen events such as Fukushima, as well as the increased number of countries now participating in the LNG markets.

In 2016, global LNG trade accounted for 258 MTPA, a 5% increase vs. 2015. There are now 34 countries importing LNG and 19 countries that

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export LNG. Approximately 28% of global LNG volumes (72.3 MTPA were traded on a spot or short-term basis.

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Netback Pricing

The concept of "netback" pricing is particularly important for producing countries because netbacks allow the countries to understand the varying value of LNG in different destination markets. Netbacks are calculated taking the net revenues from downstream sales of LNG/natural gas in the destination market, less all costs associated with bringing the commodity to market, including pipeline transportation at the destination, regasification, marine transport and, possibly liquefaction, and production, depending on the starting point of the netback.

There is no single formula for determining the netback price as it depends on specifics of the deal and is determined on a case-by-case basis, depending on the start and delivery point of the LNG sales contract and the particular destination market involved. The starting point for calculating a netback price can be at the well, at the inlet to a liquefaction plant, or at the exit of the liquefaction plant. The delivery point of the LNG sales contract can be at the liquefaction facility (a free on board (FOB) sale, or a costs, insurance and freight (CIF sale)), or at the destination market (a delivered at terminal (DAT) sale, or a delivered at place (DAP) sale). The terms DAT and DAP have replaced the term delivered-ex-ship (DES), although some parties continue to use the DES reference term.

To determine costs in netback pricing, the following terms are relevant:

Free On Board (FOB) Pricing: contemplates that the buyer takes title and risk of the LNG at the liquefaction facility and the buyer pays for LNG transportation from the liquefaction facility to the destination market.

Delivered at Terminal (DAT), Delivered at Place (DAP) and Delivered Ex Ship (DES) Pricing: contemplate that the seller retains title and risk of the

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